The answer is: Okun’s law refers to the negative relationship that exists betwee

Question

The answer is:

Okun’s law refers to the negative relationship that exists between unemployment
and real GDP. Okun’s law can be summarized by the equation:
%? in Real GDP = 3% – 2 × [? in Unemployment Rate].
That is, output moves in the opposite direction from unemployment, with a ratio
of 2 to 1. In the short run, when Y falls 5 percent, unemployment increases 2-1/2
percent. In the long run, both output and unemployment return to their natural
rate levels. Thus, there is no long-run change in unemployment.

I dont get it. Please help thanks

Explanation / Answer

I believe this is primarily drawing on your knowledge regarding the Phillips Curve, which we use to relate the general price level to the rate of unemployment. Recall that through the Phillips Curve, we see that the inflation rate and the rate of unemployment are inversely related. That is, the higher inflation is, the lower unemployment is in the short run. Remember that monetary policy can only affect the inflation rate in the long run. However in the short run, monetary policy can also have an impact on output/unemployment. If we assume the Quantity Theory of Money to be true (and we do) and further assume a fixed velocity and real output, then we have M*[V]=P*[Y] where the brackets indicate a fixed variable. We can also write this as %?M + %?V = %?P + %?Y. Since V and Y are fixed, we can replace them with zero. %?P can be expressed p. Thus we now have %?M = p. Since the Fed is engaging in contractionary monetary policy and reducing the money supply by 5%, we can assume the inflation rate will decrease by 5%. This will lead to depressed prices on goods in the short term. Firms will realize lower revenues, and will begin laying off workers, temporarily increasing the unemployment rate. This occurs in the short term because wage contracts and expectations are slightly sticky; inflation does not decrease and immediately cause workers to lose their jobs, although the lowered revenue is noticeable. As workers lose their jobs, the labor supply market will become more full; there will be an excess of labor supplied over labor demanded. This situation always results in a decrease in wages- if your neighbor is willing to work for $100/day, and you are making $500/day, you can bet as soon as your wage contract expires it will be you who are unemployed and your neighbor making the money. Given this, in the long run firms and laborers will "clear" the market; the expectation will be that the new level of inflation is the level of inflation, and the markets will adjust. By wages decreasing across the board, firms will be able to hire back workers they may have fired earlier when only revenues were depressed while wages were still high. Thus, in the long run the unemployment rate will return to what we call the Natural Rate of Unemployment, which is the rate at which an economy naturally operates in due to intrinsic, inexorable forces like Frictional Unemployment (think job search process) and Structural Unemployment (artificial increase of wages such as through minimum wage laws, labor unions, and efficiency wages). Unless something occurs to change one of these factors, the natural rate of unemployment will not change, and thus in the long run unemployment will return to this level. Hope this helps!

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.